IRS Issues Guidance on Code Section 162(m)
Including Grandfathered Arrangements and Covered Employees
August 30, 2018
On August 21, 2018, the Internal Revenue Service issued guidance under Notice 2018‑68 (the notice) to clarify certain aspects of Internal Revenue Code Section 162(m) (Section 162(m)), which was amended last year by the Tax Cuts and Jobs Act of 2017 (the act). Section 162(m) generally limits to $1 million the deductibility of compensation paid in a given tax year by certain public companies to individuals who constitute “covered employees.”
The notice provides limited guidance on:
- written binding contracts in effect as of November 2, 2017 (the grandfathered date), that are grandfathered under the Act, and
- the expanded and modified definition of employees covered by Section 162(m).
Written Binding Contracts Under Grandfathered Arrangements
The act’s provisions grandfathering certain written binding contracts likely will be of limited use for many companies. Generally, an arrangement will be grandfathered under the act if it is a written binding contract in effect on the grandfathered date and is not modified in any material respect on or after that date.
Amounts Subject to Negative Discretion
The act will apply to, and will not grandfather, compensation that exceeds an amount that a company otherwise has a legal obligation to pay under a written binding contract. Accordingly, the notice confirms that for tax years that begin after December 31, 2017, the performance‑based compensation exception will not be available for any compensation or portion of compensation subject to reduction or elimination at the company’s discretion as of the grandfathered date.
- Stock option awards that vest based on continued service granted before the grandfathered date that otherwise qualified as performance-based compensation under the pre-act Section 162(m) rules typically will continue to be treated as performance-based compensation, given the legally binding obligation by the company to issue shares under the options upon becoming vested and exercised.
- Many performance-based restricted stock unit awards granted before the grandfathered date that otherwise qualified as performance-based compensation under the pre-act Section 162(m) rules will not be grandfathered, as the company often retains discretion to reduce or eliminate payouts under them.
- Many bonus plans in effect as of the grandfathered date under which the payments would have qualified as performance-based compensation pursuant to the pre-act Section 162(m) rules also will not be grandfathered, as oftentimes the company has discretion to reduce to zero the bonuses payable under them.
When a written binding contract grandfathered under the act is renewed, the contract will lose its grandfathered status if the company had the discretion to renew or not to renew the contract. Accordingly, the act will apply, generally upon renewal, to contracts that: (a) renew automatically unless either party terminates the contract; or (b) terminate automatically unless either party elects to renew the contract.
A contract that legally binds the company through a renewal or extension solely at the discretion of the employee and without opportunity for the company to terminate the contract (other than by terminating the employee’s employment) will not cause the contract to lose grandfathered status under the act. Also, if a contract contains a renewal provision that would cause the loss of grandfathered status, the contract generally ceases to be grandfathered only if and when the renewal occurs.
Legally Binding Right to Participate
If a written binding plan or arrangement is in effect on the grandfathered date, an amount under the plan or arrangement that is required to be paid to an employee as of that date generally will be grandfathered under the act even if the employee was not yet eligible to participate in the plan or arrangement, provided that he or she either was employed with the company on the grandfathered date, or had the right to participate in the plan or arrangement under a written binding contract as of that date (for example, as promised under his or her employment agreement).
For example, assume that in October 2017, a company enters into an employment agreement, which constitutes a written binding contract, with its employee who is the company’s chief financial officer. The employment agreement promises that the employee will begin participating in the company’s nonqualified deferred compensation plan beginning in 2018 and that his or her benefits that would be accrued under the plan on that date is $3 million. Assume further that in 2021, the employee receives payment of the $3 million under the plan. Prior to the act, the company’s chief financial officer would not have been considered a covered employee under Section 162(m) and the employee is a covered employee only as a result of the act’s amendments to Section 162(m). Given that the employee had the right to participate in the company’s nonqualified deferred compensation plan under a written binding contract in effect on the grandfathered date, the $3 million paid to the employee under the plan in 2021 is grandfathered under the act, and is not subject to the $1 million deductibility limit under the act.
Principal Financial Officers
The notice provides some additional clarity with respect to compensation payable to a company’s principal financial officer under a written binding contract in effect as of the grandfathered date. To the extent that the individual has become a covered employee solely as a result of the act’s amendments to Section 162(m) now requiring principal financial officers to be considered covered employees, compensation obligated to be paid to him or her by the company under a written binding contract generally will be grandfathered under the act. The compensation does not need to qualify as performance‑based compensation (within the meaning of Section 162(m) before being amended by the act) to be grandfathered.
Material Modifications to Grandfathered Arrangements
Under the act, a written binding contract that is grandfathered nonetheless will lose its grandfathered status and be considered a new contract subject to the act if and when it is materially modified after the grandfathered date. The notice provides further guidance on changes that would qualify as material modifications.
Generally, any increase in the amount of compensation payable to the employee will constitute a material modification. However, the following exceptions apply:
- If compensation is deferred under the grandfathered contract, an increase in compensation resulting from a reasonable rate of interest or a predetermined actual investment will not be considered a material modification.
- The acceleration of the timing of compensation payable under a contract will not constitute a material modification provided that the amount is discounted to reasonably reflect the time value of money.
- A company’s election not to exercise discretion to decrease or eliminate compensation amounts under a contract will not constitute a material modification of the contract. Only the portion of a contract that is not subject to the company’s negative discretion can be considered a written binding contract under the grandfathering provisions of the act. Thus, a compensatory plan or arrangement under which the company can eliminate all of the compensation otherwise payable under it, will result in the entire plan or arrangement failing to qualify as a written binding contract.
- A supplemental payment made on a written binding contract otherwise grandfathered under the act, that does not exceed the reasonable cost-of-living increase over the payment made in the prior year under the written binding contract, will not constitute a material modification. A common example likely would be a modest increase in base salary that is grandfathered under a written binding contract.
As amended by the act, Section 162(m) provides that a company’s covered employees (i.e., those employees whose compensation is subject to the limits of Section 162(m)) for a given tax year of the company include those individuals serving as the company’s principal executive officer or principal financial officer at any time during the tax year, the next three most highly compensated executive officers during the tax year, and any individual who was a covered employee for any preceding tax year that begins after 2016. Prior to the act’s amendment, Section 162(m) had provided that covered employees include the company’s chief executive officer as of the end of the company’s tax year and the executive officers whose compensation is required to be disclosed under the U.S. Securities and Exchange Commission’s (SEC’s) disclosure rules under Item 402 of Regulation S‑K for being among the four next most highly compensated executive officers for the tax year other than the chief executive officer.
Key Changes From Prior Covered Employee Rules
Covered employees now are determined without regard to whether the executive officer is providing services at the end of the company’s tax year and regardless of whether the executive officer’s compensation is subject to the SEC’s disclosure rules under Item 402 as a named executive officer for any fiscal year of the company. The same covered employee rules apply to smaller reporting companies and emerging growth companies in the same manner as it applies to other publicly held corporations.
Tax Year Determination of Covered Employees
The determination of a company’s covered employees is based on each tax year of the company. Accordingly, in some circumstances, such as in the context of a corporate transaction that results in a shortened tax year for a company without a change to its fiscal year, the timing of determining covered employees may not coincide with when the company is required to determine its named executive officers for its fiscal year under the SEC’s disclosure rules under Item 402.
In light of the recent guidance issued under the notice, companies should review any compensatory plans and arrangements for executive officers that were in effect on the grandfathered date, to confirm whether they constitute written binding contracts grandfathered under the act. In addition, companies should continue to monitor grandfathered written binding contracts for changes that could be considered material modifications that cause the contracts to become subject to the amendments to Section 162(m) under the act. Further, companies may wish to continue removing provisions in existing compensatory plans and arrangements that address superseded rules under Section 162(m) (e.g., requirements for qualification under Section 162(m) as performance-based compensation).
For More Information
If you have any questions regarding this WSGR Alert, please contact any member of the employee benefits and compensation practice at Wilson Sonsini Goodrich & Rosati:
|John Aguirre||(650) 565-3603||Sriram Krishnamurthy||(212) 497-7721|
|Jessica Bliss||(650) 849-3470||Scott McCall||(650) 320-4547|
|Madeleine Boshart||(415) 947-2057||Michael Montfort||(202) 973-8815|
|Joe Cho||(650) 496-4013||Matthew Norgard||(650) 849-3259|
|Mark Cornillez-Ty||(650) 849-3384||David Thomas||(650) 849-3261|
|Brandon Gantus||(415) 947-2138||Jackie Tokuda||(650) 565-3904|
|Michael Klippert||(650) 849-3276||Michelle Wallin||(650) 565-3620|